A few months back we introduced the concept of “Dirty Portfolios”, that add Managed Futures to traditional asset mixes the same way one adds olive juice to a martini to get the infinitely preferable dirty martini. That piece looked at a variety of popular asset allocation approaches and showed that adding Managed Futures improved returns, reduced volatility and drawdowns. It can be found here and has a lot of background info worth reading if you missed it – and apologies in advance for the tortured Dirty Harry quotes.
We received a lot of good feedback! One note we received a few times; “You guys looked at a lot of stock heavy asset allocations, but what about us fixed income investors. Can Managed Futures help diversify here also?”
In keeping with the movie references, here we take a look into fixed income and “license to kill” James Bond(s) quotes. Luckily, he liked a martini already, so we are halfway there. With the Spectre of high inflation causing a SkyFall in fixed income, could portfolios have been neither shaken nor stirred? (Sorry)
A Brief History Of Bond Yields
Sean Connery’s Dr. No hit screens in 1962. The US 10-year yield was right around where it closed 2022, 3.9%. Bond yields and Bond films peak at the same time with For Your Eyes Only in the early 1980s. 14 years later, as Timothy Dalton took over, yields were still high at 8.3%. As Pierce Brosnan pulls on the tuxedo they are 6.0%, as Daniel Craig takes over, 4.6%. In particular, this past 40 years or so have been incredibly good for bond portfolios, as yields reached what looks to be a nadir early in the pandemic at 0.5%. (We’ve ignored Lazenby because…well it was just one movie. Really good one though). Additionally, taking some poetic license, “The Brosnan Years” will be referred to as “The Best Years” for the remainder of this piece.
Since the premiere of the latest (last?) movie, No Time to Die in September 2021, the Fed has raised rates 450bps. In 2022 fixed income markets, there was no place to take (A Quantum of) solace. The Bloomberg US Agg Total Return Index returned -13.0%, the largest annual loss in decades. Managed Futures strategies performed well; as a proxy, the MLM Index EV (15V) returned 36.7%. Managed Futures strategies have a habit of doing well when other markets struggle, as it tends to hone in on the factors causing distress. 2022 was no different. The year was characterized by war in Ukraine driving commodity prices higher and high inflation causing interest rates to rapidly rise from pandemic induced lows, which in turn contracted earnings multiples in equity markets. For those parts of the bond markets with credit components, spread expansion added to the duration woes. Emerging market fixed income also suffered.
For the fixed income allocator, the benefit of Managed Futures strategies is that they can be positioned either long or short directly in fixed income markets. Managers typically trade a wide variety of global bond markets at different points on the yield curve and utilize leverage. This means you don’t need to add a very large amount of the strategy to a Fixed Income portfolio to see meaningful benefits, and at the top portfolio level the Managed Futures portfolios work to move around the entire portfolio duration systematically. Managed Futures strategies also get exposure directly in other markets impacted by fixed income prices – commodity exposures participate in inflationary and deflationary themes while currency markets are often expressions of relative interest rates. Indeed, in 2022, the shorts in the Japanese Yen and longs in the oil complex helped generate returns. Over the longer term, Managed Futures strategies are uncorrelated to fixed income markets, adding uncorrelated elements to portfolios improves risk adjusted portfolio returns.
Portfolio Allocation – The Dirty Answer
As we did in the last piece, here we try and answer the main questions on how to use Managed Futures. How much should someone allocate? Fixed income markets are not all the same, ranging from short duration US Treasuries to long duration emerging market or high yield corporate bonds. The “right” amount of a Managed Futures allocation we think would vary depending on the type of fixed income portfolio. Different risk profiles and different asset mixes lead to different answers. We think that even the most risk averse portfolios could benefit from some amount of Managed Futures. Below we show the addition of Managed Futures to some different sectors of the Fixed Income markets, creating a “Dirty” version. As parts of the Fixed Income markets are newer than others, some of the portfolios go back farther than others. Data runs through the end of 2022. For the Managed Futures exposure we use a combination of the original MLM Index (15V) and the MLM Index EV (15V), as we believe it to adequately represent the space in a passive fashion. Portfolios are rebalanced monthly – if you want to Die Another Day…rebalance.
The table below shows the summary total return data over different time periods. Generally, higher total returns, lower drawdowns, similar to lower levels of volatility and much improved in 2022. Optimized solutions look for meaningful Managed Futures allocations – 20-50%.Continue reading